Chapter 10 Efficient Markets
Random walk (2)
1) day to day stock price changes are uncorrelated 2) expected return on a stock is the same every day regardless of what happened to the stock price in previous days
Long term reversal strategy (2)
1) form a portfolio of stock winners (1-6 years) and losers 2) losers outperform winners over the next year
3 errors in information processing
1) overconfidence 2) conservatism 3) sample size neglect and representativeness
Active money management
can test efficiency of market by comparing performance of professionally managed funds with performance of market index
Regret avoidance
individuals who make decisions that turn out badly have more regret when that decision was more unconventional
Anomalies
investment strategies which seem to earn high returns without being very risky
Semistrong form efficient market
publicly available information does not predict future retruns
Abnormal return
return in excess of that earned by other investments with same risk
Prospect theory
risk seeking with respect to losses
What is regret avoidance consistent with? (2)
size premium and long term reversals
According to EMH, what is the only way to get higher returns?
taking on more risk
Media content and sentiment
text analysis of NY times counting the number of positive and negative words each day
What does the medium term momentum strategy indicate?
that the market is not weak form efficient
If a market is semistrong form efficient, what should mutual fund managers earn?
the same returns to those of the average investor in the market
Evidence against market efficiency (5)
1) market crashes and bubbles 2) volume of trading too high 3) volatility of returns too high: dividends not volatile 4) existence of too many mutual funds 5) return anomalies
2 Event study results
1) prices adjust quickly following public news announcements 2) prices drift slowly prior to public news announcement, perhaps due to trading on private information
3 behavioral biases
1) regret avoidance 2) affect 3) prospect theory
3 characteristics that attract investors to firms
1) reputations for socially responsible practices 2) attractive working conditions 3) produce popular products
Technical analysis (3)
1) searching for recurring and predictable patterns in prices 2) attempting to take advantage of slow adjustments to changes in fundamentals 3) used in weak form efficient
3 implications of market efficiency
1) security selection less important 2) market timing not possible 3) little role for professional money managers
3 characteristics of behavioral finance
1) some anomalies are consistent in behavioral "irrationalities" 2) individuals don't always process info correctly 3) individuals make inconsistent or systematically suboptimal decisions
4 ways to measure risk of strategy
1) standard deviation 2) downside risk 3) market beta 4) multifactor model
Evidence for semistrong form market efficiency (3)
1) stock prices appear to move randomly 2) new public information appears to be quickly incorporated into prices 3) professional money managers do not consistently beat the market
Random walk and market efficiency (2)
1) there is no useful information in past price changes 2) if prices reflect all relevant information, then prices change only when "new" information arrives
Fundamental analysis (3)
1) using economic and accounting information to value securities 2) studying income statements, industry news, and the macro economy 3) used in semistrong
Abnormal return formula
Asset return - market return
Market efficiency paradox
If markets are perfectly efficient, it is not profitable to acquire information and seek superior investments, but if nobody acquires and trades on information, markets cannot be efficient.
Affect
a feeling of good or bad that investors may attach to investment in a stock
Event studies
assess the impact of an event on asset prices and returns
Beat the market
consistently earning a positive abnormal return
Market efficiency
degree to which stock prices reflect all available information
Downside risk
does the strategy sometimes perform very poorly?
Why will insider trading not "beat the market" in strong form efficiency?
evidence suggests prices move before public announcement
Medium term momentum strategy
form a portfolio of stock winners that performed very well (2 moths - 1 year) in recent past and a portfolio of stock losers
What is affect consistent with?
high average returns of "sin" stocks and low average returns of prominent admired companies
Efficient market hypothesis
major financial markets reflect all relevant information at all times
What does the LT reversal strategy indicate?
markets are not weak form efficient
Strong form efficient market
no information of any kind, public or private, is useful for predicting future returns
Efficient market
one where information is quickly and accurately reflected in prices
Weak form efficient market
past prices, trading volume, and short interest do not predict future returns
Sample size neglect and representativeness
people commonly act as if a small sample is just as representative of the population as a large sample
Conservatism
people tend to be too slow in updating their beliefs in response to new evidence
Overconfidence
people tend to overestimate the precision of their beliefs and the strength of their abilities
Why do traders tend to increase risk throughout the day?
they've experience losses earlier in the day